A bumpy ride. That's the least that can be said of the distance covered in the first quarter. The markets plummeted nearly 20% in the aftermath of the first Fed interest rate rise in December and out of fear of global recession: the emerging markets cracked, commodities fell and the Chinese renminbi depreciated.
The resurgence came in the middle of February. The US central bank projected two instead of four interest rate rises; the fall in the dollar stabilised exchange rates in the emerging markets; oil bottomed out and is now twice the level it was in mid-February.
What lies in store in the coming half of the year? The international environment remains fragile. The emerging markets have stabilised. The Fed's hesitation at quickly raising the interest rate staunched the outflow of volatile portfolio investments. The US economy went through a temporary dip in the first quarter, but domestic demand remained resilient. In Europe, however, growth was surprisingly strong. Sustained, albeit somewhat slower, growth is certainly on the cards here for the rest of the year.
One of today's enigmas is why recovery can't really get going in Europe. It certainly has nothing to do with the more restrictive budgetary policy than in the US. Between 2011 and 2013, spending cuts shaved 1 percentage point off euro-area growth and 1.6 percentage points off growth in the US. Today, both regions have a slightly expansive budgetary policy.
At the moment, the relatively greater restraint on growth in Europe than in the US stems from the ever-high risk premiums for companies (due to a fragmented European capital market) and the lack of investment. In addition, structural problems (a rigid labour market, fragmented product market) are holding growth in productivity back at levels beneath the US's. The inexorable calls for the ECB, European Commission and other bodies to carry out grass-roots reform are still falling on deaf ears.
Divergent interest rate policies
Over the year as a whole, we expect moderate growth of 1.6% in the euro area and 1.7% in the US (owing to the weak first quarter). Monetary policy remains flexible. There is a good chance that Japan could evolve towards an even more negative interest rate. The ECB is sitting on the sidelines to wait and see what the impact will be of the latest measures, such as buying up corporate bonds and granting new long-term loans. A further fall in the US dollar could galvanise America into more action.
We do not expect any such fall. The Fed is determined to raise the interest rate. However, the circumstances are not yet ideal. The recent uninspiring labour report would indicate that the next rate rise will sooner be something for September, with perhaps a second rate rise before the end of this year. The differences between the Fed's intentions and the ECB's should push the exchange rate up towards 1.10 US dollars to a euro. If the Fed continues to put off, then, in time, there is a risk that the market will reposition itself. It isn't then ruled out that the dollar will take an utter thrashing and the euro will sky-rocket, with all the deflationary consequences that would bring – a nightmare scenario for ECB president Mario Draghi.
Of course, there are other risks that could turn this basic scenario on its head. Rampant inflation as a result of the US labour shortage would give bond markets a thorough pasting. The interest rate markets are counting on just one rate rise this year. However, the largest risk is in the short-term. Brexit would certainly undermine consumer and producer confidence in the UK, and also in the rest of the euro area, with the markets slumping by 20%. A sharp drop in economic growth is then fact. If other countries were to follow the British example, a domino effect also couldn't be ruled out.